In a decision strongly favorable to defendants in securities fraud actions, the United States Supreme Court has interpreted the Private Securities Litigation Reform Act of 1995 (PSLRA) to require a plaintiff to allege in the complaint facts that would give rise to a "cogent and compelling" inference of scienter, not merely a reasonable or permissible inference (Tellabs, Inc. v. Makor Issues & Rights, Ltd, No. 06-484, June 21, 2007). The PSLRA has always required plaintiffs to state with particularity not only the facts constituting the alleged violation but also the facts giving rise to a "strong inference" that the defendant acted with scienter (i.e. the defendant's intent to deceive or defraud). Congress opted not to define "strong inference," however, and the courts of appeals have been split on the standard to be used in deciding whether the facts alleged in the complaint do indeed give rise to the statutorily required "strong inference." The Seventh Circuit in the Tellabs case — in refusing to affirm the lower court's dismissal of a Section 10(b) fraud action against both the corporate and individual defendants — decided that a complaint should be allowed to survive if the plaintiff simply alleged facts from which, if true, a reasonable person could infer that the defendant acted with scienter. On the other hand, the Sixth Circuit had adopted a stricter standard in which the plaintiff was entitled only to the most plausible of competing inferences.
In an 8-1 decision authored by Justice Ginsburg, the court decisively came down on the side of a stricter standard. The opinion squarely held: "A plaintiff alleging fraud in a Section 10(b) action … must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference. ... Stated otherwise, [the plaintiff] must demonstrate that it is more likely than not that the defendant acted with scienter." As a result of this decision, district courts, when faced with a motion to dismiss a section 10(b) action, must first accept all factual allegations in the complaint as true. Second, the district court must consider the complaint in its entirety together with documents referenced in the complaint and matters of which the court can take judicial notice. Finally, the district court, in determining whether the facts give rise to a "strong inference" of scienter, needs to take into account plausible opposing inferences. Crucially, the Seventh Circuit had declined to enter into this comparative inquiry because it believed that such a comparative weighing might impinge on a plaintiff's right to a jury trial. The Supreme Court dismissed that concern and held that the required inquiry was necessarily comparative because the strength of an inference could not be decided in a vacuum. Of course, the Supreme Court held that the inference need not be irrefutable, or even that it be the most plausible of competing inferences, but it must be "cogent and compelling, thus strong in light of other explanations." Ultimately, the court remanded the case so that the lower courts could re-examine the allegations of the complaint in light of the court's decision.
The court was certainly guided by its view that one of the twin goals of the PSLRA was to curb frivolous, lawyer-driven litigation. Interestingly, in attempting to effectuate this goal, Justice Scalia (with whom Justice Alito agreed), concurred only in the judgment of the court. Justice Scalia would have further tightened the interpretation of "strong inference" by holding that the test should be "whether the inference of scienter (if any) is more plausible than the inference of innocence." It will be interesting to see if Justice Scalia's view gains sway in the future given that the court clearly seems to be on a course of tightly interpreting Congress' intent as reflected in the PSLRA. Justice Stevens, meanwhile, as the lone dissenter, saw no need to go into a comparative inquiry but instead would have entered into a probable cause analysis of the facts alleged, since Justice Stevens considered probable cause roughly the same as "strong inference." Obviously, this standard, which would have been more favorable to plaintiffs, found no support with the court.
Both Tellabs and the court's recent decision in Bell Atlantic Corp v. Twombly almost certainly presage a far rockier road for plaintiffs in the securities litigation field. Defense counsel need to be even more alert to the possibilities of raising motions to dismiss based on plaintiffs' failure to meet the "cogent and compelling" standard set out in Tellabs.
About Buchanan's Securities Litigation Practice Group
The attorneys in our group have wide experience in representing corporations, their officers and directors in SEC enforcement proceedings, hostile takeover litigation, shareholder class and derivative actions, and SEC and NASD investigations. We have represented professional service firms, including commercial banks, underwriters, accounting firms and brokerages, in actions related to the federal securities acts, broker/dealer consumer actions, insider trading allegations, and all manner of securities arbitrations overseen by the NASD, NYSE and other SROs.
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